Beware the Boom in Stock Buybacks
They can mask transfers of wealth away from shareholders.
Executive stock options? Though originally billed as a way to align management and shareholder interests, they are now reviled by investors as a way for management to quietly loot the companies they are paid to run. When done in excess they massively dilute shareholder value over time. They also encourage short-termism and a fixation on raising the company’s stock price in the short term at the expense of planning for the company’s long-term future.
Along the same lines, share repurchases have become popular in recent decades as a tax-efficient alternative to cash dividends. Earnings paid out as dividends are taxed twice, at both the corporate and individual investor levels. But when a company uses that same cash to buy back its own shares in the open market, it can boost earnings per share without creating a taxable event.
And unlike dividends, which are usually paid quarterly, stock buybacks can be done sporadically as cash allows. Raising the regular dividend is a risky move because it is viewed as a firm commitment, and management doesn’t want to be in that awkward position of having to slash the dividend later if conditions take a turn for the worse. But buybacks can be done quietly behind the scenes and can be stopped at any time without drawing too much unwanted attention.
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Again, it sounds good…in theory. In practice, companies tend to have awful timing. They buy their stock when prices are high, but in a market panic, when prices are low, they are often unable to buy because a bad economic outlook causes them to hoard cash. In the worst cases, they actually have to issue new stock…at low prices that dilute shareholders. Buying high and selling low; this is not exactly a formula for maximizing shareholder value.
But the most insidious aspect of stock buybacks is that they often fail to reduce the number of shares outstanding.
Hold the phone…How exactly could a share buyback not reduce the number of shares outstanding?
Simple. The company retires shares bought at full price on the open market to soak up new shares issued at a discount to fulfill employee and executive stock options.
That might be a little hard to digest at first, so allow me to explain. Many companies incentivize their workers with employee stock purchase plans in which the workers are allowed to buy shares of the company stock at a discount of anywhere from 5% to 50%. Alternatively, the company might match employee contributions share for share.
While the company and the workers tend to view these perks as “free money,” they are not free at all. The shareholders pay in the form of share dilution. And the same is true of executive stock options. The new shares created by the executed options dilute the existing shareholders. It may not be a cash expense, but it is a major reduction of shareholder wealth.
To prevent these new shares from diluting earnings per share, management “mops up” by buying back shares on the open market. The problem is that they effectively buy these shares at full price and sell them to employees at a discount, with the shareholders eating the difference. It’s highway robbery that is, sadly, perfectly legal.
So, how big of a problem is this?
Let’s take a look at the most recent buyback data compiled by Factset. Across the S&P 500, the “buyback yield” over the past two years has averaged a little over 3%. This means that over the preceding rolling 12 months, the companies of the S&P 500 have collectively repurchased a little over 3% of their shares outstanding. Over the course of two years, that means that their shares outstanding should have dropped by around 6%.
So, how did that work out in practice?
Not so well. The number of shares outstanding has only fallen by a cumulative 2% over the past two years.
Not all companies are equally guilty here. There are plenty that are legitimately using their excess cash flow to reduce their share counts to the benefit of their shareholders. But market-wide, the boom in buybacks is mostly a sleight of hand used to hide a massive transfer of wealth from shareholders to management and labor.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog. As of this writing, he was long MCD, O and UL.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Charles Lewis Sizemore, CFA is the Chief Investment Officer of Sizemore Capital Management LLC, a registered investment advisor based in Dallas, Texas. Charles is a frequent guest on CNBC, Bloomberg TV and Fox Business News, has been quoted in Barron's Magazine, The Wall Street Journal, and The Washington Post and is a frequent contributor to Yahoo Finance, Forbes Moneybuilder, GuruFocus, MarketWatch and InvestorPlace.com.
-
Hotels That Give You the Best Value for Your Money, According to Guests
New research reveals the best hotels in the U.S. for value for money according to hotel guests — and why they’re demanding more from their stay.
By Charlotte Gorbold Published
-
Want to Earn $1 Million More Over Your Lifetime? Do This
It's simple: Go to college or a trade school. It's an investment that will pay huge dividends for the rest of your life. And the benefits go far beyond money.
By Brian Evans, CPA, PFS Published
-
Want to Earn $1 Million More Over Your Lifetime? Do This
It's simple: Go to college or a trade school. It's an investment that will pay huge dividends for the rest of your life. And the benefits go far beyond money.
By Brian Evans, CPA, PFS Published
-
What Impact Does Politics Have on Insurance?
Some governors choose their state's insurance commissioner, while other states elect theirs, and that person has power over insurance issues, including rates.
By Karl Susman, CPCU, LUTCF, CIC, CSFP, CFS, CPIA, AAI-M, PLCS Published
-
If You're the Millionaire Next Door, You May Be a Terrible Spender
Good job on all that great saving. Now you need to start spending some of that hard-earned retirement savings on the things you love.
By Joe F. Schmitz Jr., CFP®, ChFC® Published
-
Who Will Be the Beneficiaries of Your Wealth?
Deciding who you want to inherit your wealth, as well as when and how, is a crucial first step in estate planning. Here are the four beneficiaries to keep in mind.
By Adam Frank Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Talkin' 'Bout My Generational Wealth: Baby Boomers
With retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
By Alvina Lo Published
-
How to Avoid a Big Hassle if Your Financed Car Gets Wrecked
How an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
By H. Dennis Beaver, Esq. Published
-
Estate Planning Strategies to Consider as Election Nears
Are big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
By David Handler, J.D. Published